Opening a Coverdell May Require Shopping Around

Question: I'd like to open a Coverdell account for my child, but my fund company doesn't offer them. How do I go about getting one?

Answer: A Coverdell Education Savings Account can be a great way to save for educational expenses, especially for families with precollege costs. A Coverdell is similar to a Roth IRA in that contributions grow tax-free and distributions are also tax-free if used for qualified educational expenses. (For details on which expenses are covered, see this Internal Revenue Service document.)

Coverdell accounts are often mentioned alongside 529 college-savings plans in that both offer tax-advantaged ways to save for education. But there are some key differences. Most significantly, even though both account types can be used to cover college costs, the Coverdell also can be used for expenses from kindergarten through 12th grade. That's a big plus for families sending their kids to private elementary or high schools, or who are paying for tutoring or other educational services out-of-pocket. Also, unlike 529 plans, which offer a set menu investment portfolios based on mutual funds, with a Coverdell, investors get to choose whichever mutual funds, exchange-traded funds, stocks, and bonds they prefer.

Along with these advantages, however, come some drawbacks. One is that annual Coverdell contributions are limited to $2,000 per beneficiary, which limits the account's value as an educational savings vehicle. Also, Coverdell contributions may only be made by those with modified adjusted gross incomes of less than $110,000 if single, or of less than $220,000 if filing jointly. Finally, 529 contributions are often deductible on your state tax return, whereas Coverdell contributions are not.

Despite these drawbacks, Coverdells can be an attractive option for families looking for a way to save for a broader range of educational costs and use a wider array of investment options than a 529 can provide. Plus, there's no reason they can't utilize both account types--for example, using a Coverdell for K-12 expenses and a 529 for college expenses.

Another option is to open a Coverdell through a brokerage. Charles SchwabSCHW, E*Trade Financial ETFC, TD AmeritradeAMTD, Scottrade, and Merrill Edge (formerly Merrill Lynch) all offer Coverdell accounts and allow investors to capitalize on one of the account type's main advantages: the freedom to build a tax-advantaged investment portfolio using whichever funds, ETFs, stocks, and bonds the account holder prefers. But as appealing as that may sound, there are potential shortcomings to this strategy. Although fund companies typically allow customers to make contributions whenever they please at no cost, a brokerage typically charges per transaction. That means that any time you make a contribution to the Coverdell through a brokerage, you may be required to pay trading fees.

So, even though one advantage Coverdell accounts have over 529 plans is freedom of choice, you could end up paying more for access to a wider variety of investment options. Before opening a Coverdell, make sure you understand any extra costs involved. Saving for education is a great idea, but you shouldn't have to pay an arm and a leg to do it.